Taxing Americans abroad

I'm still waiting for that wonderful moment during a pub quiz when the question is asked: "Which two countries tax their citizens on their worldwide income on the basis of citizenship rather than residence?" The answer to this question, as any self-respecting tax lawyer will know, being Eritrea and the United States. It is, perhaps, a reasonable assumption to make that Eritrea's enthusiastic approach to taxing its citizens gives rise to less headaches for individuals worldwide than the effects of the long arm of the US Internal Revenue Service (IRS). The plight of American citizens who are subject to US tax on their worldwide income and gains, despite not being resident in the US, has been brought into topical and sharp focus by the joyful nuptials between Prince Harry (a UK resident and national) and Meghan Markle, now the Duchess of Sussex (a US citizen and we may assume now a UK resident).

Accidental Americans

For many people (perhaps not for the Duchess of Sussex, who will no doubt have been carefully advised on her ongoing US tax reporting obligations), the effect of the US's citizenship basis of taxation can come as a horrible and expensive surprise. US citizens and green card holders residing outside the US all fall within the scope of US tax on worldwide income. While no accurate estimates exist, it has been cited that there are more than three million individuals living outside the US who are in default of their US tax and reporting obligations. Some US citizens move away from the US and do not realise that they must continue filing returns and paying tax in the US.

However, a more commonly encountered situation is of those individuals who are completely unaware of their US citizen status and may, in fact, never have lived in the US. Take the example of our fictitious Mr John Doe, born in the UK to a UK citizen father and a dual US/UK citizen mother. John's mother left the US in her mid-twenties, while John has never stepped foot in the US and has never held a US passport. I have come across this scenario enough times with UK resident clients to know that given John Doe's fact-pattern, he may well be a US citizen.

Compliance headaches

What are some of the practical implications for the individual living in the UK who finds out that they're a US citizen? Staying with our friend, John Doe (who happens to be a very wealthy man with assets held worldwide), who is advised that he is indeed a US citizen, he discovers that, as a result of his US citizen status, he has inadvertently defaulted on filing previous years' US tax returns in which he should have been reporting his worldwide income and gains.

Furthermore, John Doe may well have been defaulting on his US reporting obligations under the Report of Foreign Bank and Financial Accounts rules (returns made in compliance with these rules referred to as FBARs). These rules require US persons to report to the IRS in each tax year the values in bank, brokerage or other financial accounts located outside the US in which that person has a 'financial interest' or 'signature authority', where the aggregate value of such accounts exceeds USD $10,000 at any point in the previous tax year. For those married couples (such as Prince Harry and Meghan) where only one of the couple is a US person, this can mean that a joint interest in a foreign bank account is fully reportable under the FBAR rules, even if that account was entirely funded by the non-US person spouse. The financial penalties for failing to submit FBAR reports can be hefty, and in certain circumstances, may end up being assessed as half of the maximum balance (during the year in which no report was made) in the unreported financial account.

John Doe's situation may become bleaker still if he has reportable interests in any non-US incorporated companies that fall within the US's rules for the taxation of Controlled Foreign Corporations (CFCs) or Passive Foreign Investment Companies (PFICs).

It is not just the IRS that can give those US citizens living in the UK a headache. Many individuals are fully aware of their US person status, and have taken professional US tax advice so that they are fully compliant with all of their US reporting obligations. Unfortunately, the interaction between the US and UK tax systems can sometimes throw up unexpected (and again, expensive) issues. An example of this is the US citizen who, while living in the US, puts in place a comprehensive US estate plan further to the advice of his US lawyers. Part of that estate plan involves the substantive funding by the US individual of a lifetime trust, of which he acts as sole trustee. This individual subsequently moves to the UK without taking any UK tax advice until after he has become UK tax resident. When he finally does take some UK tax advice, he is horrified to discover that his US lifetime trust has become UK tax resident on account of his role as trustee and his own UK tax residence status. A costly bill from HM Revenue & Customs may follow.

Transparency initiatives mean nowhere to hide

It is no exaggeration to state that the advent of worldwide transparency initiatives (under which international tax information exchange between certain jurisdictions is made obligatory) means that it is now more unwise than ever to put one's head in the sand regarding potential historic tax issues.

For US persons living abroad, the Foreign Account Tax Compliance Act (FATCA) requires financial institutions outside the US to provide the IRS with information on financial accounts held by US nationals and residents. Transparency initiatives such as this, combined with a reluctance on the part of tax authorities to enter into benign tax settlement agreements with tax payers under amnesty programmes (the US closed its Offshore Voluntary Disclosure Programme on 28 September this year), it is now more imperative than ever that international individuals are fully aware of their worldwide tax and reporting obligations, and take advice accordingly.

This article was first published on WealthBriefing.com